How To Spot Toxic Investors

5 min read

Have you ever had a fever?

You know, the kind where you can feel your body fighting itself. The same body that you love and care for, that you’ve spent all your life nurturing suddenly becomes a point of pain, anxiety and maybe death.

Well, that’s exactly how you’ll feel if you commit the blunder of taking on a toxic investor into the your company.

Ideally, the investors you take on should believe in you and your business and can add value on the long term. That value could be in the form of introductions made by such investors contributing to business development deals, partnership opportunities, or additional rounds of financing.

A toxic investor does the exact opposite of all these. These toxic individuals have the same type of patterns that repeat over time and that entrepreneurs should be aware of when fundraising. So here are the things you should look out for when considering investors:

Greed

There is a distinct difference between conducting a profitable business and being greedy. If all the investor wants to do is take, take, take, and milk every dime from your startup, then your success is not going to be sustainable or even enjoyable.

This investor may rush you to an IPO or acquisition, and that’s not necessarily a good thing. Selling out your startup’s soul isn’t going to feel good if you care deeply about it.

Even if all you care about is the money, remember that if you plan to move on to additional business ventures, this startup is going to be at the top of your resume. It’s your calling card.

What to look out for and possible red flags:

During the negotiation process, keep your eyes peeled for the addition of certain clauses that are out of market. This will tell you what type of individual you are dealing with. A greedy investor only wants to take and will find every opportunity to do so.

If this person is showing these signs at the “dating” stage, imagine how things could turn out if the company is not doing well.

Some clauses on your offering documents may not mean anything today but you can bet, they’ll have seismic implications in the future.

For that reason you want to carefully read and understand what everything means on the documents of your financing.

Lack of Ethics or Morality

A greedy investor is bad, but an unscrupulous, shady investor (aka a shark) is a nightmare. When you enter into business with people who have no values, things will get ugly pretty fast.

And even if you decide to hold onto your own values all through the relationship, you will be damaged simply by association.

It’s important to note that, in any bad business, the investor is usually better insulated than the entrepreneur.

The founders who have their hands on the controls usually end up as scapegoats and this kind of investor has no qualms about throwing you under the bus.

Also remember that partnerships go both ways. Savvy investors with values also look out for good qualities in founders, too.

It may not be easy to discern who’s ethical. So make sure to read up on your investors. If a considerable section of the media are reporting the same troubling news about an investor, please believe them.

The Conqueror/Takeover Type

If you know Steve Jobs’s story, you can probably empathize with the heartache and frustration of being booted from your own startup. Every entrepreneur who read that just went, “Perish the thought!” In their heads.

Well, the conqueror type of investor will revive that thought and make it a reality.

Nobody wants all of the blood, sweat, and tears poured into growing a startup to end with getting kicked out of your own business right before or just as it blossoms.

Watch out for term requests that appear to suggest that your venture would turn into something different, or you as the founder could end up being relegated to the position of a powerless pawn—or worse, shut out altogether.

Red flags include an investor asking you to increase the stock option pool over 15% as that means there is an intention to replace top management.

In any case, as a founder you should avoid a dilution of over 25% per round of funding. You should try to have as much control as possible for as long as you can. Especially at an early stage when your vision needs to remain intact.

One last piece of advice:

Ask portfolio companies of that investor that has failed in the past about how the investor behaved during the tough times. That gives you first hand information on how the investor reacts during difficult times (which is when you‘ll probably see the ugly side of any investor).

As much as founders would love to close the funding ASAP so that they can get back to the “fun stuff” of building the business, it is critical to understand that relationships with investors are long term.

If your gut feeling is telling you to stay away from that money then you should keep searching for your perfect match even if it would take you longer to close the round of financing.

Remember the best investors make founders feel like gods, remain faithful in the face of uncertainty and act as support systems for your business.